Horizon Effects and Adverse Selection in Health Insurance Markets
35 Pages Posted: 15 Feb 2017 Last revised: 16 Jul 2020
Date Written: December 16, 2017
We study how increasing contract length affects adverse selection in health insurance markets. Although health risks are persistent, private health insurance contracts in the United States have short, one-year terms. Short-term, community-rated contracts allow patients to increase their coverage only after risks materialize, which leads to market unraveling. Longer contracts ameliorate adverse selection because both demand and supply exhibit horizon effects. Intuitively, longer horizon risk is less predictable, thus elevating demand for coverage and lowering equilibrium premiums. We estimate risk dynamics using data from 3.5 million U.S. health insurance claims and find that risk predictability falls significantly with horizon. Counterfactuals using these estimates suggest that a reform implementing two-year contracts would increase equilibrium coverage by 12-19 percentage points and yield average annual welfare gains of $600-$900 per person. A third of these effects are driven by insurers' response and the rest by changes in consumer expectations.
Keywords: health insurance, adverse selection, contract length
JEL Classification: I13
Suggested Citation: Suggested Citation